The Board of Directors in Hedge Fund Governance

The Board of Directors in Hedge Fund Governance Peter G. Szilagyi Chong Wei Wong Judge Business School – University of Cambridge WORK IN PROGRESS 17 December 2012 Abstract Hedge fund boards have historically been overlooked as an institution lacking relevance and substance. Directors are indeed appointed by the fund manager, mostly supplied by the fund’s service providers and director services, and often lacking in skills and incentives to monitor the fund. Nonetheless, they face growing pressure post-crisis from both investors and regulators to fulfill their fiduciary duties. This paper investigates the role and effectiveness of hedge fund boards for the first time, using hand-collected data from hedge fund documentation previously unavailable for academic research. We find several important results, including evidence that (i) board independence leads to improved fund performance, (ii) directors with risk management experience reduce fund risk without affecting returns, and (iii) funds deliver superior returns and lower risk when they give voting rights to investors (including to elect directors). We conclude that the board can be a very useful source of control in hedge funds, whose traditional governance model fundamentally focuses on the realignment of managerial interests. JEL classification: G11, G23, G32, G34, G38. Keywords: Hedge funds, board of directors, investor rights, operational risk, agency problems, corporate governance. Corresponding author. Tel: + 44 (0) 1223 764 026. Fax: + 44 (0) 1223 339 701. Email address: [email protected] (P. G. Szilagyi). 1. Introduction Since the modern hedge fund was conceived by Albert W. Jones in 1949, hedge funds have moved from being a cottage industry to being major players in financial markets. Today, an estimated 20,000 hedge funds operate in over 45 countries, managing about US$2 trillion of assets around the world. The industry has also become a key concern for policymakers, as the occasional violent hedge fund collapses have transmitted substantial systematic risk throughout the financial system. The Global Financial Crisis unfolded in August 2007 with the collapse of two Bear Stearns hedge funds, which brought down the investment bank and sent shockwaves through asset-backed securities markets. This paralleled the collapse of Long Term Capital Management (LTCM) a decade earlier, which had already triggered about the potential for systemic risk if a hedge fund failure led to the failure of its counterparties. Such hedge fund failures are important reminders of the significant conflicts of interest that exist between hedge fund managers and their investors. The governance issues confronted by investors range from excessive leverage and risk taking, strategy drifts, suspension of redemption and fund gating to performance and portfolio valuation manipulation and outright fraud. Whether these concerns can be adequately addressed within the existing corporate governance model of hedge funds is a key area of the post-crisis debate on hedge fund regulation1. The remarkable failure of regulators and fiduciaries to prevent the US$80 billion Madoff Ponzi scheme2 has certainly spelt the crisis of this model, with regulators and investors increasingly turning their attention to those technically responsible for hedge fund governance – the board of directors. The relevance of the board in hedge fund governance is a controversial issue that, up until now, has not been investigated in the academic literature. While hedge fund boards are faced with growing pressure to fulfill their fiduciary duties and take an active role in the governance process, they were previously overlooked by both investors and regulators as an institution lacking relevance and substance. The governance model of hedge funds is designed to provide managerial flexibility to achieve flexible, tax efficient structures circumventing on-shore tax regulations3. Fund managers argue that in this context, corporate governance is an irrelevant process and the board is an operational constraint; the emphasis being on the realignment of managerial interests through ownership, incentive fees, and the use of third party service providers. Then, the board serves only to fulfill minimum requirements set forth by the company laws and regulations of off-shore jurisdictions. 1 In explaining its December 2004 decision to introduce hedge fund registration (Rule 203 (b)(3)-2), the SEC suggested that the very structure of hedge funds creates the motivation and opportunity for fraud and other misconduct – with their lack of transparency and incentive-based fee structures being primary risk factors. The SEC cited 51 enforcement cases on fraud allegations against hedge funds, and said that over 400 hedge funds and 87 fund advisors were under investigation. 2 The Bernard L. Madoff Investment Securities LLC was formally not a hedge fund. However, it was described as the world’s largest unregistered hedge fund organized as a fund of funds The Madoff scheme is also an example of the failure of fiduciaries such as funds of funds and professional managers who conduct due diligence and select investments for investors. 3 Hedge funds are most commonly set up by the fund manager in an off-shore tax-exempt jurisdiction, through the establishment of an investment fund and an investment management company. The latter is then engaged in an investment advisory service agreement with an on-shore investment management company, which manages the fund’s assets from an on-shore regulated jurisdiction such as the US. For a number of reasons, the economic relevance of the board also appears to be negligible in practice. First, in most hedge funds, only management shares have voting rights, with investors holding participating non-voting shares. Thus, directors are appointed by the fund managers themselves and are pervasively supplied by fund administrators, legal advisors, prime brokers and other related entities providing overlapping services. This presents a major source of potential conflicts of interest. Fund directors also often come from within a close network of the hedge fund community, and there is a prevalent use of fund director services, where some professional directors sit on hundreds of hedge fund boards. Second, directors are often ill-qualified in the first place to assume the fiduciary duties of monitoring, advising and disciplining the fund manager, with no accounting and fund administration skills or risk management and buy-side experience to understand fund trading4. Third, directors may to a limited extent participate in policy discussions on performance and risk management, but board meetings are usually infrequent, informal and held at the discretion of the fund manager. Finally, due to tax considerations, fund directors are generally located in offshore jurisdictions away from the management company. These issues are relevant because the corporate governance of hedge funds is being more closely examined today than at any other time in their history. Moody’s Investor Service (2011) points out two key reasons for this trend. Firstly, regulators around the world are introducing more demands on fund managers from both a compliance and risk management perspective. While it is too soon to gauge the full impact of new regulations such as the Dodd-Frank Act in the US and AIFMD in Europe, they are certain to challenge fund managers with respect to their depth of reporting and standards of accountability. And secondly, the investor base of hedge funds has shifted from high net worth individuals to institutional investors. Institutions spend much more time and resources on due diligence, and aside from analyzing investment performance, they put great emphasis on evaluating fund governance and oversight. Indeed, institutional investors have been lobbying both individual fund managers and regulators – even the Cayman Islands Monetary Authority – for governance reform. This paper examines the role and effectiveness of hedge fund boards for the first time, relying on data from hedge fund documentation provided by a fund of funds and previously unavailable for academic research. While the analysis is highly preliminary with additional work underway, it already delivers a number of important findings. First, independent directors with relevant skill-sets are a non-trivial source of hedge fund governance. Funds with independent boards perform considerably better, while the presence of directors with risk management experience reduces risk-taking without affecting performance. Second, when fund investors are given voting rights, there is both an improvement in fund performance and a reduction in risk. This confirms Brown, Fraser and Liang’s (2008) earlier result that hedge funds benefit from sophisticated investors performing due diligence. Finally, we show significant erosion in fund performance in the presence of managerial incentive problems, caused 4 As a guideline, the Alternative Investment Management Association (AIMA) suggests that a fund board include “a diversity of skills, experience and backgrounds”. It says that in addition to accounting and administration skills, directors “must have the necessary collective expertise to understand the Fund’s trading”. AIMA also describes “best practice for any Fund would be to have a majority of independent offshore directors and to avoid appointing directors who represent the advisers or service providers to the fund because of the potential for conflicts of interest” (http://www.hedgedirector.com/white%20paper.pdf).

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